If given a choice, many businesses would prefer outsourcing work to independent contractors instead of hiring employees because doing so saves a lot of money.
For example, numerous taxes — such as Social Security, Medicare and unemployment contributions — paid by employers do not apply to independent contractors Also, businesses do not have to withhold federal income taxes for independent contractors.
In addition, if you aren’t matching and withholding, you are not filing the related, numerous reports. Instead of filing employment tax returns and W-2s, you simply file an annual IRS Form 1099-MISC for payments of $600 or more to independent contractors. You don’t even have to file that if your independent contractor is operating as a corporation.
If you hire independent contractors instead of employees, you can avoid a host of expenses such as overtime, retirement benefits, vacation pay and sick leave, time off for pregnancy and family deaths, and all types of insurance.
Estimates runs as high as $30 billion annually as to the amount the IRS loses in taxes as a result of independent contractors underreporting their income. That’s the major reason the IRS doesn’t fool around when it comes to going after employers who misclassify employees as independent contractors.
Consequences for this misclassification include penalties, back taxes and retroactive payment of benefits such as minimum wage payments. For willful misclassification, the law provides for jail time.
Unfortunately, there is no clear definition of independent contractor. Generally, if the employer has the right to control and direct the worker then he or she is an employee and not an independent contractor. An independent contractor is someone who is obligated to provide a product or service using his or her tools, methods and techniques.
You can get a determination from the IRS on whether a worker is an independent contractor or employee by completing Form SS-8. This form is available on the IRS Web site at www.irs.ustreas.gov. Form SS-8 lists a number of questions. The answers to these questions determine whether the worker is an independent contractor or employee.
The IRS considers 20 factors in examining the relationship between the worker and the business in order to determine the status of the worker as employee versus independent contractor. These factors are divided into three categories — behavioral control, financial control and the type of relationship itself. The greater the control the business has, the more likely the worker is an employee.
Behavior control factors are analyzed to see whether the business has the right to direct and control how the work is done through instructions or training.
Financial control factors examine whether the business can control the financial and business aspects of the worker’s job. For example, evidence that the worker is an independent contractor would be if he or she could incur an economic loss and if that person is offering services to the public-at-large.
In examining the type of relationship, the IRS reviews written contracts to see whether the business is providing the worker with benefits that are commonly provided to employees, such as vacation, sick pay and insurance. Another key factor in this area is the duration of the relationship; the longer the relationship, the more likely the worker is an employee.
If you are just starting a business, there is little risk in obtaining an advance ruling from the IRS regarding the proper classification of your workers. If you have already classified workers as independent contractors and you ask the IRS for confirmation that you made the right decision, you may be opening a Pandora’s box.
If the IRS disagrees with your past actions, expect an audit.
Daniel H. Kolber ([email protected]) is a partner with Gambrell & Stolz LLP and specializes in securities, investments, financing and general business law. Reach him at (404) 589-3413.
